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Fuse is Lit! Target2 Imbalances Hit Crisis Levels: An Email Exchange With the ECB Over Target2

Eurozone Target2 imbalances have touched or exceeded the crisis levels hit in 2012 when Greece was on the verge of leaving the Eurozone. Others have noted the growing imbalances as well.

I had a couple of questions for the ECB regarding Target2, which they have answered, I believe disingenuously.

First, we will explain Target2, then we will take a look at various charts, viewpoints, and the email exchange with the ECB.

Target2 Background

Target2 stands for Trans-European Automated Real-time Gross Settlement System. It is a reflection of capital flight from the “Club-Med” countries in Southern Europe (Greece, Spain, and Italy) to banks in Northern Europe.

Pater Tenebrarum at the Acting Man blog provides this easy to understand example: “Spain imports German goods, but no Spanish goods or capital have been acquired by any private party in Germany in return. The only thing that has been ‘acquired’ is an IOU issued by the Spanish commercial bank to the Bank of Spain in return for funding the payment.”

This is not the same as an auto loan from a dealer or a bank. In the case of Target2, central banks are guaranteeing the IOU.

Target2 also encompasses people yanking deposits from a bank in their country and parking them in a bank in another country. Greece is a nice example, and the result was capital controls.

If Italy or Greece (any country) were to leave the Eurozone and default on the target2 balance, the rest of the countries would have to make up the default according to their percentage weight in the Eurozone.

Target2 Imbalances

Those numbers are as of December 2016. A check of the Bundesbank Target2 Balance as of January 31, 2017 shows a new record high of €797 billion.

As of December 2016, if Italy were to exit the Eurozone, Italy would owe €356.6 billion to Germany, Luxembourg, and a couple other small creditors.

Vast liabilities are being switched quietly from private banks and investment funds onto the shoulders of taxpayers across southern Europe. It is a variant of the tragic episode in Greece, but this time on a far larger scale, and with systemic global implications.

There has been no democratic decision by any parliament to take on these fiscal debts, rapidly approaching €1 trillion. They are the unintended side-effect of quantitative easing by the European Central Bank, which has degenerated into a conduit for capital flight from the Club Med bloc to Germany, Luxembourg, and The Netherlands.

This ‘socialization of risk’ is happening by stealth, a mechanical effect of the ECB’s Target2 payments system. If a political upset in France or Italy triggers an existential euro crisis over coming months, citizens from both the eurozone’s debtor and creditor countries will discover to their horror what has been done to them.

As always, the debt markets are the barometer of stress. Yields on two-year German debt fell to an all-time low of minus 0.92pc on Wednesday, a sign that something very strange is happening. “Alarm bells are starting to ring again. Our flow data is picking up serious capital flight into German safe-haven assets. It feels like the build-up to the eurozone crisis in 2011,” said Simon Derrick from BNY Mellon.

The Target2 system is designed to adjust accounts automatically between the branches of the ECB’s family of central banks, self-correcting with each ebb and flow. In reality, it has become a cloak for chronic one-way capital outflows.

Private investors sell their holdings of Italian or Portuguese sovereign debt to the ECB at a profit, and rotate the proceeds into mutual funds Germany or Luxembourg. “What it basically shows is that monetary union is slowly disintegrating despite the best efforts of Mario Draghi,” said a former ECB governor.

The Banca d’Italia alone now owes a record €364bn to the ECB – 22pc of GDP – and the figure keeps rising.

Spain’s Target2 liabilities are €328bn, almost 30pc of GDP. Portugal and Greece are both at €72bn. All are either insolvent or dangerously close if these debts are crystallized.

On the other side of the ledger, the German Bundesbank has built up Target2 credits of €796bn. Luxembourg has credits of €187bn, reflecting its role as a financial hub. This is roughly 350pc of the tiny Duchy’s GDP, and fourteen times the annual budget.

Mish Questions for the ECB – January 27, 2017

Many media reports suggest the growing target2 imbalance in Italy is a sign of capital flight. ECB president Mario Draghi said it was a function of ECB asset purchases. Can you explain why Draghi is right or wrong?

Please also explain the growing target2 imbalance at the ECB itself.

Thanks
Mish

ECB Response – February 15, 2017

Dear Mr. Shedlock,

Thank you for your email and please accept our apologies for the late reply.

As regards the ECB’s own Target balance, when the ECB purchases securities under the APP, the ECB credits the account of the respective counterparty. Such counterparties are credit institutions, which cannot hold accounts with the ECB, but instead, hold accounts with national central banks. Therefore, payment for a security by the ECB automatically increases the ECB’s TARGET liability (but not necessarily the overall TARGET balance). This is discussed in the Bundesbank’s March 2016 Monthly Report (pages 53-55).

With best regards,

TARGET Hotline
EUROPEAN CENTRAL BANK

Disingenuous ECB Response

I have been talking about Target2 imbalances for years, and I do not accept ECB’s response straight up.

Euro intelligence also discussed this very question recently. They have it correct, as follows, emphasis mine:

One of the barometers of tension in the Eurozone is the number of articles in the German press questioning the euro’s advantages to the country. The publication of the latest Target2 imbalances is not helping soothe nerves. As of end January, the German surplus was at an all-time record of €796 billion, while Italy’s deficit was at a record €364 billion. The ECB argues that the reason for the gap is not the same as it was during the Eurozone crisis when the imbalances reflected capital flight.

Philip Plickert writes in FAZ that this argument does not tell the full story. It is true, of course, that international banks based in London sell bonds to the Bank of Italy from their Frankfurt-based branches – so that the asset purchases result in transfers of central bank money from Italy to Germany. But why do the sellers not replenish their portfolios with purchases of Italian bonds, shares or other assets? Instead, they take the money and invest in Germany. So this is still capital flight – except that it works indirectly through the asset purchase programme.

Simple Target2 Explanation

Reader Lars writes: “Target 2 is a settlement system. When imbalances arise it’s because transactions are not settled. For example, Luigi in Italy transfers his €1 million from his Monte dei Paschi (MdP) account to his new Deutsche Bank account. MdP does not have the €1 million and has to borrow it from Bank of Italy. The Bank of Italy has to borrow the €1 million from Bundesbank. So at the end of the day, Luigi gets the €1 million into his account in DB but the Bank of Italy now owes €1 million to Bundesbank.”

Pater Tenebrarum at the Acting Man blog commented via Email “I agree with the eurointelligence view that the steep Italian and Spanish deficits are still a testament to capital shunning various countries. To put it very simply: people managing large sums of Other People’s Money for institutions subject to fiduciary duty continue to have doubts about the euro’s survival, and rightly so.

Reader Lars replied: “It seems to me that the ECB is trying to complicate matters and kick the ball into the tall grass. In regards to the ECBs €160 billion Target2 deficit, it might be the case that the ECB has borrowed from Bundesbank and then lent the money to other national central banks (NCBs) because the Bundesbank has not been willing to do all the heavy lifting itself. Is the Bundesbank shunning risk at local NCBs?”

Rating Agencies Where Art Thou?

The rating agencies should be all over this issue but they are not. Here are two possible explanations.

The rating agencies are in bed with central banks or creditors

They do not understand Target2

Huge Insurmountable Problem

Target 2 is one of the least discussed and least understood problems in the Eurozone.

Jens Weidmann, Bundesbank president, allowed nearly €800 billion in credit to build on his watch. One has to wonder: Is Weidmann moving into illegal territory?

Egon von Greyerz, Founder & Managing Partner, Matterhorn Asset Management AG, made a comment similar to what I have stated many times: “Germany is in bigger trouble than Italy, Spain, or Portugal. Those countries can’t pay so Germany will have to foot the bill.”

Alternatively, the Bundesbank and the ECB are going to print money to cover those losses!

Greece alone is unlikely to trigger a crisis now, but Italy, Spain, or France could.

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56 thoughts on “Fuse is Lit! Target2 Imbalances Hit Crisis Levels: An Email Exchange With the ECB Over Target2”

“As of December 2016, if Italy were to exit the Eurozone, Italy would owe €356.6 billion to Germany, Luxembourg, and a couple other small creditors.

What’s the likelihood Italy could ever pay back €356.6 billion?”

Under the wonderful and exquisite Eurozone system, there would not be any problem if Italy could not pay the 356.6 Billion Euros – the system is rigged never to fail. The ECB and EU would “bail out” Italy by lending a further 356.6 Billion Euros to it, immediately recycling this money to Germany, Luxembourg, and the other creditors. No creditor would be harmed in the making of this mov(i)e. And Italy would never fall into “default” although each bail-out would add to the debt burden of the Italian taxpayers. We can see this system in operation in Greece, where its awesome design and procedures are on display.

A great element of the awesome Euro/ECB/EU system is that no institutionally important creditor will ever come to harm, and no major debt will ever go into default, no matter how unpayable the total debts of taxpayers become.

Yes, except the citizens of any country may (and have) notice/d that something is up, whether it is how their economy, politics, society has changed, and they are questioning, on multiple, often opposing, fronts whether to accept or how to change their circumstance. Should a country decide to leave the Euro, and that is a national political choice, the ECB has no jurisdiction as arbiter of the debt fall out. That is to say what Germany has lent to other countries via Target2 ( and outside of it), may simply ‘evaporate’ in an extreme, and in a less extreme lead to many years of legal battles and recriminations to reclaim part of it.

Europe is in a lot of trouble in my opinion, it still goes round but is not going anywhere much, people know this and I am not sure how long they will put up with it. Countries that used to be buoyant and cheerful, even if a little hectic, are now subdued and uptight, there is a lot of resentment around.

Yes, my overblown “praise” for the rigged Euro system was intended as sarcasm. I see the Euro system as a typical “feel good”, “everything is awesome” politically-designed econo-political system that is set up to enrich the rich and powerful while deluding the public into thinking the system was set up for their benefit.

Target 2 was set up as a bank accounting system to compensate for trade and financial flow imbalances. It has become clear that Target 2 has become a means by which Germany’s export surpluses are financed – a form of vendor financing. As Germany enjoys its export surpluses to other Eurozone member countries, the banking systems and taxpayers of the importing countries see their accumulated trade deficits become accumulated debts of their banks and taxpayers.

Germany’s stout defenses of the Euro system and rules against bail-outs by countries of their failing banks (witness the situation in Italy), and defense of rules against ECB bail-outs; are meant to maintain Germany’s position as the big winner in the trade flows in the EU, and meant to protect the accumulated debt surplus owed to German banks. Germany, however, is quite willing to see these rules ignored if the bail-out of a country or a bank protects German banks from losses – as is readily evident in the “bail-outs” of Greece, where the money used to “bail out” Greece is added to Greece’s debt pile and 90% or more of the bail-out money actually goes directly to German and French banks that lent recklessly to Greece while Greece and Greeks went on spending (and German and French export buying) frenzy.

The Euro system is unsustainable for many reasons, and one of the most evident flaws is that countries (like Italy) are unable to compensate for lower productivity by reducing their currency exchange rates. German unemployment is low while unemployment and consumer debt in the PIIGS are disastrously high.

The situation in Portugal, Spain, Ireland, and Italy is very similar to that of Greece, but default has been avoided by slightly more adept “extend and pretend” papering over of problems. However, the problems have not been solved, rather dealing with them has merely been delayed.

“As of end January, the German surplus was at an all-time record of €796 billion,”

How much surplus does Britain have? I ask because it seems obvious to me that Britain is owed money and know they aren’t going to get it. If the EU thinks Britain owes THEM 60 billion, Britain will just come back with, “Actually, YOU owe US 200 billion.”

Britain is in serious trouble with its balance of payments, the size of which has been disguised by significant gold exports to China. Once the City of London shrinks, and with it the export of services so the balance of payments deficit will turn into a crisis and interest rate policy will be set by the need to attract additional foreign capital. I think the Pound is in more trouble than the Euro and I think Britain is in more trouble than Europe. Mind you the US is not doing too badly. If we consider that corporations raised nearly $4 trillion of new capital in 2016 for a mere 1.6% growth in GDP $280 billion increase that translates into $13 dollars for every $1 dollar of nominal growth. Shades of China.

Do you have figures for the gold exports? UK doesn’t have as high per centage as you might expect so just doesn’t have the value to make a massive difference.

Thoughts here are that GBP could over strengthen as a safe haven after sell-off clears on Article 50. A real expectation that efforts will have to be made to keep the pound down.

Agree about exports given a shrinking CoL and debt/GDP likely to deteriorate.

Interesting to know what you think of impact on Germany as UK was 2nd biggest net market for Germany. France bigger gross but smaller net. UK hitting the skids could hit Germany and therefore EU quite substantially.

Gold flows into and out of UK correlating with bull and bear markets. Net imports into UK in 2016 were 1000 metric tonnes (by comparison Chinese net imports were 1300mt in 2016). Here are the last decade’s UK imports/exports of bullion (I track this myself using Eurostat trade data):

So Germany really just has a surplus of non-performing loans? Yeah, Germany wants to be paid, but it seems obvious that they aren’t going to get squat. Which means that the German surplus is merely a noncollectable, theoretical accounting surplus, whereas the actual tangible items wound up outside of Germany.

Ultimately, as Mish has pointed out many times in the past, this surplus is a much heavier cross for Germany to bear than it is to those who owe the money.

Ratings agencies are in bed with them imho, turning a blind eye on purpose.
IMF mixed in too, helping cover against much exposure, in love with the Euro.

Fall-out is politically and financially explosive with Euro as #2 trade weighted currency.

It is looked at as a closed system so why should anyone possibly be concerned?

The outcome is forced fiscal union under German control with Bundesbank pulling ECB strings. Watch it happen if Italy tries to leave and is slapped with a bill to balance the books. This is the same country that has been under technocrats for a while , they don’t have the where withal to do anything but comply.

I wouldn’t want to be in Greece’s shoes, but they may end up better off than Germany if this is ever let unwind. They already have austerity while it will come as a great shock to Germany….and their millions of Muslim dependents.

Schulz would be the perfect leader positioned in Germany when this unwinds – preaching solidarity to keep the German masses on side. Timing couldn’t be better.

It would cost Germany to return to DM but if Merkel wants to win it’s what she should offer to open up a gap to her advantage.

You could look at is as any Germans capital loss in the Euro is the price they pay to become dominant and taking budget control from debtor countries and forcing German fiscal discipline on the weak ones. The cost of integration.

“Tim Geithner, Obama’s original Treasury secretary, has described his first meeting with Schäuble, at a G7 finance ministers’ meeting in February 2007:

I said at that dinner, that meeting, you know, because the Europeans came into that meeting basically saying: “We’re going to teach the Greeks a lesson. They are really terrible. They lied to us. They suck and they were profligate and took advantage of the whole basic thing and we’re going to crush them,” was their basic attitude, all of them….

But the main thing is I remember saying to these guys: “You can put your foot on the neck of those guys if that’s what you want to do. But you’ve got to make sure that you send a countervailing signal of reassurance to Europe and the world that you’re going to hold the thing together and not let it go. [You’re] going to protect the rest of the place.”[67]”

At this late date, I am hard pressed to think of any big European bank that is solvent when their books are looked at sans politics. All the big French banks, the big Italian banks, Santander (Spain), the Dutch banks — all insolvent without state guarantees. The EU can’t bail all the banks out even if they had German support (which they do not). The Target2 numbers are just really bad kabuki theater.

And after years of dilly dallying, it is no longer clear if Deutche Bank is still solvent. They probably are, but its a gray area at best. Certainly they are in no position to bail out other German banks, much less the e-insolvent union.

Someone is just going to tell Mario Draghi to shut up… in so many words. They can insult him right to his face and there is absolutely nothing he can do about it. The EU is coming apart anyway, the banks are already insolvent, and a “promise” from the ECB without German backing isn’t worth mentioning.

Everyone knows the EU/ECB isn’t going to admit their experiment failed, so everyone knows they will not enforce target2 anymore than they will suddenly start enforcing the maastricht treaty.

The BOJ plus the ECB are printing about $200 billion per month. While this money starts out as holdings of hinky southern sovereign debt it doesn’t stay there. It moves into safer assets including US stocks, US real estate, and German bonds and equities. Add the capital flight from China at a $trillion and now the capital flight out of lower Europe reveals the impotence of central banks to stop this tide of world wide capital flight. Fuses lit indeed.

No way to say beforehand, at best Euro accounts would be converted into national currency, but it could run all the way through, in various shades, to a complete destruction of all existing accounts and debt with martial law and no currency until a new currency and order were installed.

So Euro cash… might not be exchangeable, or maybe in currency of nation of issue, or maybe in share of currencies if not physical cash but in a foreign account etc.

Who knows… (no-one), but sure there are plans that may or not work in that eventuality, they are not revealed or discussed publicly, and even mentioning that they exist is taboo.

Well the country is borrowing at negative rates, something that was not ‘achieved’ even in Weimar unless you count direct confiscations. On the other hand in the hyperinflation during that time payments were negative rated once you calculate the amount paid minus loss in value in the time it took someone to rush out and buy something.

So in a sense Target2 is already the mutualized debt issuance so rejected by Germany and some others, it happens under financial political control with an account attached, instead of voted political budgetary control.

The current framework is designed to save the financial system from imploding, during Weimar it was to save people’s income. In the monetary management underway it is assumed that the populations will adjust to the new order, but if they refuse to it will have failed, and the abrupt loss of value of the Euro will also mean hyperinflation has become the end result.

That memory might save Germany but destroy the Euro.
Seared into the psyche.

A way to satisfy Germany/Eurozone = Germany reinstates the DM.
Euro goes on its merry way without Germany.
It might even be a German/Dutch Euro North, everyone else Euro South.

Schauble offering tax reductions due to surplus would be stimulatory but chance it will increase German inflation further. Catch22.

It also doesn’t get Germany closer to it Maastricht 60% limit any quicker but could sideline Schulz and help keep the plebs from voting their dissatisfaction and offer the ECB some domestic cover for their actions – look, tax reductions because of the weak Euro helping German exports because of the ECB.

Funny you should ask that. The Netherlands is asking the same question, lol.
**Dutch relations with euro up for debate after lawmakers commission probe**
Feb 24 “The Netherlands’ future relationship with the euro will be comprehensively debated by its parliament following elections in March, after lawmakers commissioned a report on the currency’s future.
The probe will examine whether it would be possible for the Dutch to withdraw from the single currency, and if so how, said lawmaker Pieter Omtzigt”.http://www.reuters.com/article/netherlands-election-euro-idUSL8N1G95BX

A German business sends machines to a Spanish business. The Spanish business sends goods and services to a Spanish banker. When the German business wants the Spanish banker to send goods to them, the Spanish banker demands that voters send goods to the banker as a bailout.

So what happened to the goods the Spanish business sent to the Spanish banker? Goods sent to bankers by Spanish businesses somehow keep disappearing from the trade equations. Why didn’t bankers trade the goods received on the international market for something that Germans wanted to import? What did they do with the goods?

It will soon be too late to get your money out of Europe. The doors are closing on the various exits that exist and stock certificates in U.S. Blue Chips are among one of the few exits as are deeds to U.S. real estate.

When for instance italy leaves the euro, do you think Luigi gets his 1 million euro from DB if the central bank of italy doesn’t pay back its debt? I think DB will pay back Luigi in lire! Of course it’s far more complicated.
Marc

What odds FTT gets implemeted to help with some of this?
A good reason to chapparel banks into EU out of London after Brexit.
Relaxed capital ratios might attractive to some too.

What they fail to see is less risk is needed as soon as feasible and delaying Basel is another kick of the can. Seems expedient now but the stuff can hit the fan any time and the banks will just not have any resilience.

Systematic risk is not being reduced and doesn’t look like they even want to manage it.

Is Merkel proposing that temper tantrum before or after she fantasizes about getting EUR60 billion from the UK?

Neither will happen.

My money is on France and Italy (and now maybe Netherlands) leaving the EU before any of the Brussels Babies can implement any of their pipe dreams.

Close second scenario: Merkel gets voted out in Germany… SPD says they want to keep EU, but they can’t afford it. AfD will dump EU during victory parade. No one (CDU / SPD / AfD) has way to “save” illegal immigrant crime spree. Even if Merkel is allowed to stay (the least smelly shirt?), she no longer has the political capital to implement EU requests.

The only ‘losses’ that would occur would be the central banks with positive TARGET2 assets would lose capital. That would be totally without consequence. The ECB could restore it with another stroke of the computer keyboard, in the same way they created the TARGET2 balances in the first place to make sure all the private transactions (across borders) cleared.

A central bank is not like a commercial bank – it cannot go broke. It could operate with negative capital into perpetuity.

Bill Mitchell covers most of it here

Mario Draghi uses TARGET2 to cower Italy into staying within the Eurozone

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